Aave is considering a native Bitcoin lending market that would allow borrowers to lock Bitcoin as collateral while obtaining wrapped Bitcoin (WBTC) loans. The design, detailed in an October 14 proposal from Babylon Labs, introduces a complex settlement structure that could expose liquidity providers to losses under certain conditions.
How the Market Would Function
Borrowers would lock Bitcoin in Taproot vaults on the Bitcoin blockchain, which Aave would recognize through restricted ERC-20 accounting tokens. When a position becomes eligible for liquidation, an external liquidator would repay the borrower's debt and receive WBTC from Aave's shared liquidity pool, called a Hub.
The seized vault would then enter escrow through a settlement component known as the Swap Spoke. An arbitrageur with redemption rights could later purchase the vault by repaying the WBTC draw and accrued interest, then claim the Bitcoin after waiting through multiple days of Bitcoin's settlement window.
Alternatively, authorized application vault keepers could bypass the Swap Spoke entirely, directly repaying the borrower's debt and redeeming Bitcoin to their own key, though this route narrows the pool of available liquidators.
The Deficit Risk
The proposal creates a potential problem: if the escrowed vault's value drops below the WBTC borrowed from the Hub, a deficit occurs. When an arbitrageur purchases the vault under these conditions, the unpaid balance is recognized as a loss in the same transaction.
Under current Aave framework recommendations, WBTC protection falls outside the initial scope of funded backstops. Protection is currently planned for three core markets—WETH, USDC, and USDT—but not WBTC. This means any shortfall on WBTC draws would affect the suppliers of that Hub asset unless funded protection is added.
Governance and Implementation
Aave DAO would govern the Spokes and their funding Hubs. A 2-of-3 multisig composed of LlamaRisk, Babylon Labs, and Aave Labs would control the Swap Spoke configuration. Key decisions—including draw limits, funding levels, and any dedicated loss protection—remain outstanding.
Babylon Labs says five components have undergone audit engagements, with Coinspect, ABDK, and Zellic currently re-auditing finalized changes before mainnet deployment. The proposal includes a Request for Comment phase, a conditional Snapshot vote, and an eventual on-chain proposal with full risk parameters as next steps.
For both borrowers and Hub suppliers, the final settings on debt limits, liquidation costs, draw limits, and shortfall protection will determine the financial risk of the proposed native Bitcoin collateral market.
